There are three approached to value when we discuss real estate. You should know all three of them. Actually, you should know all three of them backwards and forwards. Today in the first of our three part series on value approaches we are going to discuss the Income Approach. Just for the record, the other two are Cost and Market(Sales).
The Income Approach is most important when you are dealing with income producing properties such as apartments, office buildings, hotels, shopping centers, storage facilities, etc. Those properties that will generate cash flow for you.
This is simply the product of dividing the annual net operating income (NOI) by the appropriate capitalization rate (CAP rate). For income producing real estate, the NOI is the net income of the real estate (but not the business interest) plus any interest expense and non-cash items (e.g. — depreciation) minus a reserve for replacement. The CAP rate may be determined in one of several ways, including market extraction, band-of-investments, or a built-up method. When appraising complex property, or property which has a risk-adjustment due to unusual factors (i.e. — contamination), a risk-adjusted cap rate is appropriate. An implicit assumption in direct capitalization is that the cash flow is a perpetuity and the cap rate is a constant. If either cash flows or risk levels are expected to change, then direct capitalization fails and a discounted cash flow method must be used.
Discounted Cash Flow
The DCF model is analogous to a net present value estimation in finance. However, appraisers often mistakenly use a market-derived cap rate and NOI as substitutes for the discount rate and/or the annual cash flow. The Cap rate equals the discount rate plus-or-minus a factor for anticipated growth. The NOI may be used if market value is the goal, but if investment value is the goal, then some other measure of cash flow is appropriate.
Gross Rent Multipler
The GRM is simply the ratio of the monthly (or annual) rent divided into the selling price. If several similar properties have sold in the market recently, then the GRM can be computed for those and applied to the anticipated monthly rent for the subject property. GRM is useful for rental houses, duplexes, and simple commercial properties when used as a supplement to other more well developed methods.
Here is a simple formula to use:
Expected Annual Income / Capitalization Rate = Market Value
$100,000 Annual Income / 10% Cap Rate = $1,000,000 Market Value